Sovereign default datapoints of the day

By Felix Salmon

July 6, 2010

CMA Datavision has released its sovereign risk report for the second quarter of 2010. It's based on CDS prices, and it makes for fascinating reading. It was a bad quarter for sovereign credit: 93% of sovereigns widened, and they widened a lot -- by 30%, on average. Spreads in France, Portugal, and Spain all more than doubled, while Greece soared from 346bp to 1,003bp, at one point becoming the riskiest sovereign in the world, trading slightly wider than Venezuela. Only one country saw its CDS spreads tighten in significantly over the second quarter: Iceland tightened in by 17% to 330bp, making it riskier than Ireland but safer than Portugal.
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CMA Datavision has released its sovereign risk report for the second quarter of 2010. It’s based on CDS prices, and it makes for fascinating reading. It was a bad quarter for sovereign credit: 93% of sovereigns widened, and they widened a lot — by 30%, on average. Spreads in France, Portugal, and Spain all more than doubled, while Greece soared from 346bp to 1,003bp, at one point becoming the riskiest sovereign in the world, trading slightly wider than Venezuela. Only one country saw its CDS spreads tighten in significantly over the second quarter: Iceland tightened in by 17% to 330bp, making it riskier than Ireland but safer than Portugal.

CMA turns all of its CDS data into a 5-year cumulative probability of default: both Venezuela and Greece are more likely than not to default at some point in the next five years, according to these numbers, while Argentina comes very close. Portugal, Latvia, Iceland, Ireland, Spain and Croatia are all in the 20%-25% range, along with Lebanon, which has long had a debt which would be unsustainable were it not for a rich, generous and patriotic diaspora.

One interesting thing is that CDS spreads don’t correspond directly with default probability: Croatia, for instance, has a 20.5% chance of default with CDS spreads at 322bp, while Spain has a higher default probability — 20.7% — while having significantly tighter CDS spread of 265bp.

The reason is that CMA is using at least two different recovery ratios. If Greece or Spain or Italy defaults (or if the US does, for that matter), then CMA assumes that creditors will get back 40% of their money. But the recovery value in countries like Croatia and El Salvador is assumed to be significantly lower, at 25%.

Both figures are low, but I don’t think that this discrepancy makes sense. It seems to me that recovery values should be inversely correlated with debt-to-GDP ratios: if you have relatively little debt, then a modest restructuring can get you back on a sustainable footing, while if you have a lot of debt — like Greece, for instance — then the haircut you’ll need to impose on your creditors is much greater. I see no good reason at all for assuming that recovery values in Croatia will be higher lower than in Greece, especially after accounting for the fact that Greece is likely to have a large number of preferred creditors in Europe who will insist on being paid back in full before private-sector creditors get anything.

I do think that in future reports CMA should make its recovery-value assumptions explicit. The CDS data is important and interesting, but the default probabilities are less so, based as they are on recovery rates which seem dubious indeed.